Merkel setback hurts EMU reform chances

Euro area 'painfully ill-prepared' for next crisis

by David Marsh in Bali

Tue 16 Oct 2018

The stunning setback for Germany's coalition parties in Sunday's Bavarian state elections will toughen Chancellor Angela Merkel's already difficult task of winning consensus for reforming and strengthening the structure of economic and monetary union. That is the widespread view of well-informed participants at the International Monetary Fund-World Bank Group annual meetings in Bali that ended at the weekend.

A background discussion issue throughout the Bali meetings was disquiet over the dispute between the Italian and German governments over the way forward for EMU. Leading politicians in the Rome administration – notably Matteo Salvini, deputy prime minister, home affairs minister and head of the populist League party – have been criticising Berlin's strictures on public deficits and calling on the European Central Bank to do more to lower Italy's borrowing costs. European officials in Bali say Salvini's call for ECB help is completely counterproductive as it closes any form of ECB leeway on Italian debt.

Complaints by the European Commission of Rome's medium-term budgetary plans have strengthened Salvini's anti-Berlin and anti-Brussels rhetoric. This has probably increased his domestic popularity and chances of becoming prime minister when Italy's next elections are held at a yet-to-be-determined date in coming months.

Merkel and the unsteady Berlin coalition of her conservative Christian Democratic Union and the centre-left Social Democrats (SPD) have been badly shaken by the Bavarian result. One of the reasons for Merkel's weakness, along with deep-seated conservative misgivings over her immigration policy, has been disquiet over her stance on monetary union. The Bavarian debacle will narrow further Merkel's room for policy manoeuvre both over budgetary squabbles with Italy and over the wider issue of strengthening the euro area's institutional architecture to help withstand the next financial crisis.

One leading German financial figure in Bali warned that the world was likely to enter a new downturn in around 15 months, and euro area countries were painfully ill-prepared for the next wave of turbulence.

The Bavarian election saw the CDU's traditional ally, the Christian Social Union, which has ruled the prosperous southern state since 1957, slump to 37.2%, its lowest score since 1950, from 47.7% in the previous election five years ago. Merkel's junior Berlin coalition partner, the SPD, fared even worse, with just 9.7%, half its result in 2013. The Green environmental party forged ahead, garnering 17.5% of the votes, while the far-right, anti-Islam and anti-euro Alternative for Germany (AfD) scored 10.2%, consolidating its rise to become Germany's official opposition party in the Bundestag, Germany's federal parliament.

The erosion of conservative support, accompanied by the AfD's ascent, raises doubts over whether Merkel will remain CDU chairman at the end of the year. The CSU's decline in Bavaria could reverberate further on the German conservatives in elections in another state – Hesse, the economically booming home to the financial capital of Frankfurt – on 28 October, when Merkel's political fate will once again be in the balance.

The Bavarian campaign was dominated by the immigration debate, signalling the long-lived repercussions of Merkel's decision to allow more than 1m refugees to enter Germany in 2015. According to conservative monetary officials in Bali, an important contributor to her overall weakness has been unease among core voters over a slackening of monetary orthodoxy within EMU, epitomised by the shift to negative interest rates and massive quantitative easing since 2014 – both highly unpopular in Germany. The Bundesbank has led criticism of the ECB's policies – so much so that some mainstream politicians blame the German central bank for indirectly supporting the AfD.

Italy's ruling politicians have had discreet contact in recent weeks with senior officials in the SPD-led Berlin finance ministry, as well as with the higher echelons of the ECB. However, this has failed to calm Rome's criticisms of central features of euro area policies. German officials have been anxious, in their public comments, not to inflame passions in Rome. But their private comments have been highly critical of Italy's departure from pre-set European budgetary rules. 'With Socialists [in the Berlin finance ministry] like these as friends, we don't need enemies,' commented ruefully one high-level Italian financial figure in Bali.